1. The banking system

The banking system in the countries of Eastern Europe, introduced along with socialism in the immediate aftermath of World War II, was fashioned after the mono-bank model in vogue from earlier times in the Soviet Union. All banks were nationalized and merged into one single bank known as the National Bank in Bulgaria, Hungary, Poland, Romania, and Yugoslavia and the State Bank in the CSFR. The single bank (the National Bank hereafter) combined the functions of a central bank and commercial bank activities. At the same time, specialized institutions were created to mobilize household deposits, and in the areas of foreign trade and business investment. ^3/ Measured in terms of number of bank branches per person, banking was not very well developed in Eastern Europe. In October 1989, for example, Warsaw had only 41 bank branches, about one tenth of the density of branches in Western European cities of comparable size.

Imbedded in the socialist system, banks in Eastern Europe traditionally provided loans to enterprises necessary to carry out their output and inventory accumulation targets in accordance with the central plan for material production. ^4/ Banks were not mandated or motivated to pay great attention to the quality of assets since such quality was determined by the Central Economic Plan through a “carefully” worked out profile of present and future profitability of borrowing enterprises or sustained subsidization. With almost all production activities run and hence guaranteed by the state, the role of asymmetric information and delegated monitoring services in explaining the existence of banks in socialist economies seems to have been limited. ^5/ The primary reason for the existence of banks was the irreversibility of long-run investments and the high liquidation costs associated with interruption of any project midstream.

Even if an enterprise had money, it could not acquire real resources without permission from the planning agency; any activity detailed in the plan was automatically financed by banks or the government. Only the household sector was not subject to detailed planning, except through rationing of goods. The financial system was characterized by a limited range of assets--mainly currency and bank deposits. Enterprises held financial assets largely in the form of bank deposits, many of which were earmarked; cash holdings were restricted, and utilized mostly for wage payments. ^6/ Credit was available as working capital or investment loans from banks. Enterprises also obtained investment funds from budgetary and extrabudgetary fiscal sources, such as State Investment Credit Fund in Bulgaria and the General Investment Fund in Yugoslavia. ^7/ In contrast, households received and effected payments almost exclusively in cash and, in the absence of any alternative, deposited their savings in the one and only Savings Bank. The volume of currency was set by the planners at a level necessary to finance wage payments and household consumption. The volume of enterprise credit was set at the level necessary to finance interenterprise transactions in line with the gross production level targeted in the plan.

The method of credit allocation was direct, with the banking system acting as an administrative arm of the planning organ. Full administrative control over prices, wages and quantities was taken for granted, and the State, as the owner of all means of production, received all profits and losses of every enterprise and bank. Hence the interest rate was motivated either by the administrative efficiency of an overt remuneration for intertemporal substitution, or by deviations in actual economies from a perfectly functioning planned socialist system. The rates of interest had little relation to the return on capital or the maturity structure of loans, and played a insignificant allocative role.

The daunting task of drawing up a consistent inter-sectoral central plan in a complex economy, and the growing divergence between command and response in a system with ill-designed incentives, over time led to an emphasis on decentralized decision making. ^8/ In the banking sector, this decentralization manifested itself first in the breaking up of the monobank model into a two-tier banking system, with the creation of a traditional central bank and hiving off the nongovernmental loan portfolio of the erstwhile monobank to several commercial banks. Yugoslavia, like in many other areas, was a pioneer in this regard and abolished the monobank system in 1954. The other countries initiated the two-tier system only in the late 1980s and early 1990s. ^9/ In 1987, Hungary transferred the commercial banking activities to three large banks, while Bulgaria established eight commercial banks. In both these countries the banks had broad sectoral concentrations. At the beginning of 1989, Poland established nine commercial banks of roughly equal size organized on a regional basis. The CSFR set up three independent banks at the beginning of 1990: two commercial banks organized on a regional basis and an investment bank. Since December 1990, Romania has transformed its National Bank into a traditional central bank, and established the Romanian Commercial Bank to hold the National Bank’s commercial and deposit portfolio. Romania also transformed the specialized banks into commercial banks.

At the end of the 1980s, almost all the governments of Eastern Europe had committed themselves to the development of an autonomous, sound, competitive, and profit-oriented financial sector to facilitate an efficient distribution of credit and hence resources across sectors, territory and time. The financial sector reform required for such a transformation entails the resolution of a host of legal, organizational, and technical issues. ^10/ For example, the appropriate laws must be passed, licensing, regulatory and prudential control systems established, the necessary manpower trained and appointed, and so on. The ongoing process of transformation will take years to complete.

2. Interaction among reform, instability, and banking insolvency

a. Reform and instability

Financial sector reform in these countries was initiated against the background of general economic malaise and crisis. Most economies in Eastern Europe have suffered from chronic excess demand, as witnessed by quantity rationing, queues, bribery of shop assistants and service personnel and low or zero retail stocks, rather than in immediate inflation and current account pressures. The root cause of the shortages was microeconomic and structural. State ownership of all means of production and the lack of material incentives led to wasteful use of energy, material inputs and labor, while emphasis on planned adjustment of quantities without adequate adjustment of relative prices led to supply bottlenecks and misallocation of resources.

The microeconomics of the system interacted with its macroeconomic aspects. First, there was, and in some economies there continues to be, an inflationary overhang or forced savings. Second, the conscious effort to maintain a domestic price structure very different from the corresponding international one, led to highly overvalued currencies. ^11/ Slippages in plan implementation resulted in external deficits and a buildup of external debt. Third, the priority attached to quantitative plan fulfillment relative to financial targets led to “planners’ tension” or “taut” microeconomic plans whereby output targets are maximized subject to constraints on planned inputs and technical coefficients. This in turn resulted in “…more fixed-capital formation to be planned within any given rate of saving by reducing the inventory-to-output ratio,” ^12/ and excessive vulnerability of the system to exogenous supply failures. Fourth, the emphasis on quantitative output targets and protection of full employment in an environment of virtually fixed prices entailed widespread supplementation of enterprise revenues by budgetary subsidies and bank credit. ^13/

During the 1980s the growing inefficiency of the system, adverse external shocks, and various attempts at partial reform worsened the macroeconomic imbalances in these economies. ^14/ The introduction of more substantial and comprehensive reforms, starting in the late 1980s (the lifting of price controls, realignment of exchange rates to restore international competitiveness, and partial liberalization of external trade) exposed and intensified the conflict that reform generates between the goal of efficiency in the medium term and stability in the short term.

Table 1 reports inflation, current account balances, and income growth in the countries of Eastern Europe during 1980-1990. As can be seen, inflation became a persistent problem from as early as 1981 in Poland and Yugoslavia, and in Hungary, to a lesser extent, since 1988. Inflation accelerated markedly in all countries in 1990. Developments in the external positions of the Eastern European countries were more varied; Hungary and Poland, which were furthest along the path of reform but also two of the most burdened by external debt, managed to reverse their persistent current account deficits in 1990; the other countries suffered a sharp worsening of their external positions. Real growth has been poor in all six countries since the mid-1980’s, and large falls were experienced everywhere in 1990. Preliminary data for 1991 suggest that these tendencies have if anything worsened for most of the countries, and that these economies remain severely disrupted. This instability, in turn, has diminished both the tangible benefits from and euphoric popular enthusiasm for reform.

Table 1.

Eastern Europe: Some Selected Macroeconomic Indicators

^1/Relates to year-on-year average inflation in retail or consumer price index.

^2/Relates to only retail prices of goods prior to 1990. The methods of calculating the price index are different for 1980-85, 1986-89, and 1990.

^3/Refers to global balance of payments.

^4/Growth in net material product at constant prices, as reported in membership paper and RED.

^5/Growth in net material product at constant prices, as reported in Prust et. al. (1990).

^6/Figures prior to 1986 from “Rocznik Statystyczny 1990”, Rok L. Warszawa, pg. 113.

^7/Growth in gross social product for 1989 and 1990.

Table 1.

Eastern Europe: Some Selected Macroeconomic Indicators

	1980	1981	1982	1983	1984	1985	1986	1987	1988	1989	1990
	Rate of Inflation 1/
Bulgaria 2/	14.0	0.5	0.3	1.4	0.7	1.7	2.7	2.7	2.5	6.4	26.3
Czechoslovakia	2.9	0.8	5.1	0.9	0.9	2.3	0.5	0.1	0.2	2.3	10.8
Hungary	9.3	4.6	7.2	7.4	8.4	7.8	5.2	8.4	16.1	17.1	30.1
Poland	9.4	21.2	100.8	22.1	15.0	15.1	17.7	25.2	60.2	251.1	585.8
Romania	1.5	2.2	16.9	5.2	1.1	-0.4	2.0	0.5	2.9	0.6	4.7
Yugoslavia	…	46.2	29.4	39.1	56.8	75.7	88.1	118.7	198.9	1,258.1	583.8
	Current Account Balance
	(In millions of U.S. dollars) 3/
Bulgaria	953	92	115	6	503	-147	-1,035	-710	-144	62	-751
Czechoslovakia	…	225	557	848	955	937	168	371	1,093	939	-1,310
Hungary	-577	-893	-534	-180	39	-455	-1,362	-676	-572	-571	377
Poland	-3,417	-3,986	-1,941	-1,581	-1,083	-982	-1,106	-379	-107	-1,409	3,067
Romania	-2,420	-833	1,040	1,160	1,719	1,239	1,489	2,043	3,922	2,514	-3,254
Yugoslavia	-2,317	-959	-473	275	478	833	1,100	1,248	2,487	2,427	-2,364
	Real GDP Growth
Bulgaria 4/	…	5.0	4.2	3.0	4.6	1.8	5.3	4.7	2.4	-0.3	-12.0
Czechoslovakia 5/	2.9	-0.1	0.2	2.3	3.5	3.0	2.6	2.1	2.3	0.7	-1.1
Hungary	0.2	2.9	2.8	0.7	2.7	-0.3	1.5	4.1	-0.1	-0.2	-4.0
Poland 6/	…	-10.0	-4.8	5.6	5.6	3.4	4.2	2.0	4.1	0.2	-12.0
Romania	…	…	4.0	6.0	5.9	-0.1	2.4	0.8	-0.5	-5.8	-7.9
Yugoslavia 7/	2.3	1.5	0.4	-1.1	1.9	0.5	3.5	-1.0	-2.0	0.8	-7.5

^1/Relates to year-on-year average inflation in retail or consumer price index.

^2/Relates to only retail prices of goods prior to 1990. The methods of calculating the price index are different for 1980-85, 1986-89, and 1990.

^3/Refers to global balance of payments.

^4/Growth in net material product at constant prices, as reported in membership paper and RED.

^5/Growth in net material product at constant prices, as reported in Prust et. al. (1990).

^6/Figures prior to 1986 from “Rocznik Statystyczny 1990”, Rok L. Warszawa, pg. 113.

^7/Growth in gross social product for 1989 and 1990.

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Table 1.

Eastern Europe: Some Selected Macroeconomic Indicators

	1980	1981	1982	1983	1984	1985	1986	1987	1988	1989	1990
	Rate of Inflation 1/
Bulgaria 2/	14.0	0.5	0.3	1.4	0.7	1.7	2.7	2.7	2.5	6.4	26.3
Czechoslovakia	2.9	0.8	5.1	0.9	0.9	2.3	0.5	0.1	0.2	2.3	10.8
Hungary	9.3	4.6	7.2	7.4	8.4	7.8	5.2	8.4	16.1	17.1	30.1
Poland	9.4	21.2	100.8	22.1	15.0	15.1	17.7	25.2	60.2	251.1	585.8
Romania	1.5	2.2	16.9	5.2	1.1	-0.4	2.0	0.5	2.9	0.6	4.7
Yugoslavia	…	46.2	29.4	39.1	56.8	75.7	88.1	118.7	198.9	1,258.1	583.8
	Current Account Balance
	(In millions of U.S. dollars) 3/
Bulgaria	953	92	115	6	503	-147	-1,035	-710	-144	62	-751
Czechoslovakia	…	225	557	848	955	937	168	371	1,093	939	-1,310
Hungary	-577	-893	-534	-180	39	-455	-1,362	-676	-572	-571	377
Poland	-3,417	-3,986	-1,941	-1,581	-1,083	-982	-1,106	-379	-107	-1,409	3,067
Romania	-2,420	-833	1,040	1,160	1,719	1,239	1,489	2,043	3,922	2,514	-3,254
Yugoslavia	-2,317	-959	-473	275	478	833	1,100	1,248	2,487	2,427	-2,364
	Real GDP Growth
Bulgaria 4/	…	5.0	4.2	3.0	4.6	1.8	5.3	4.7	2.4	-0.3	-12.0
Czechoslovakia 5/	2.9	-0.1	0.2	2.3	3.5	3.0	2.6	2.1	2.3	0.7	-1.1
Hungary	0.2	2.9	2.8	0.7	2.7	-0.3	1.5	4.1	-0.1	-0.2	-4.0
Poland 6/	…	-10.0	-4.8	5.6	5.6	3.4	4.2	2.0	4.1	0.2	-12.0
Romania	…	…	4.0	6.0	5.9	-0.1	2.4	0.8	-0.5	-5.8	-7.9
Yugoslavia 7/	2.3	1.5	0.4	-1.1	1.9	0.5	3.5	-1.0	-2.0	0.8	-7.5

^1/Relates to year-on-year average inflation in retail or consumer price index.

^2/Relates to only retail prices of goods prior to 1990. The methods of calculating the price index are different for 1980-85, 1986-89, and 1990.

^3/Refers to global balance of payments.

^4/Growth in net material product at constant prices, as reported in membership paper and RED.

^5/Growth in net material product at constant prices, as reported in Prust et. al. (1990).

^6/Figures prior to 1986 from “Rocznik Statystyczny 1990”, Rok L. Warszawa, pg. 113.

^7/Growth in gross social product for 1989 and 1990.

Given the steep decline in output experienced in the countries of Eastern Europe in the recent past, there is an urgent need to create a system that preserves and promotes economic activities that yield positive value added. A financial collapse should not be allowed to destroy whatever viable enterprises have been inherited over from yesterday’s socialism and prevent the emergence of new enterprises. Calvo and Frenkel (1991) have underscored the importance of this point by emphasizing the need to “…delink the fortunes of enterprises that ought to go out of business from those that should continue operations”.

1. The Basic Model

a. Banks not only provide transaction services but also fulfill a supervisory function by exploiting their superior access to information about their clients, and serve to spread risks. But perhaps most importantly, banks transform short-term liabilities into long-term assets to satisfy the demands of both consumers and enterprises. Banks therefore depend on their ability to attract a continuous inflow of deposits and to recover loans from borrowers. Hence the stability of a banking system depends on expectations about the continued solvency of the constituent parts of the system. When confidence in the banking system is weak, intermediation will be difficult or impossible, and investment financing will be hard to obtain. Output will suffer, with a suboptimal capital stock and limited opportunities for intertemporal substitution. A temporary decline in confidence can lead to a bank run, which in turn can have deep and lasting real effects as borrowers are forced into liquidation, investment lending is shut down, and the expectation of future bank solvency is undermined.

b. Time is discrete and indexed by t; time subscripts are dropped whenever ambiguity is not thereby created; there are an infinity of periods. All agents are sufficiently small that each takes prices and the behavior of others as unaffected by his own decisions.

A cohort, of constant size, is born each period and lives for two periods. The young receive an endowment E_t = aE_t-1, a > 1, of the investment good, and may inherit any financial assets of past generations that have not been disposed of. Only the old consume. ^26/ Each unit of the endowment can be converted into K units of the consumption good or sold to firms. Thus the investment good is an input which may even be interpreted as labor. ^27/ Neither the investment nor the consumption good can be stored as inventory. An investment of I yields sI units of the consumption good after one period and SI units after two periods. It is interesting to concentrate on the case where S > K > s, S > 1. The capital stock depreciates entirely after two periods. There is a government which absorbs G_t of the consumption good, where G_t is a fixed proportion γ < 1 of the final consumption in the economy in any period. ^28/ Government consumption is financed by seignorage, which adds ΔM_t to M_t, the stock of outside money at the start of the period.

Banks hold cash and loans to firms as their assets and their liabilities consist of nontradable demand deposits. Banks provide an intermediation service which transforms short-term savings into long-term investments. Note that by the time the investment matures an individual alive when it was undertaken is dead. Individuals can only hold cash or deposits as stores of value, and no individual can “go short” in any asset. In notation, banks in period t lend an amount B to firms, which promise to repay LB at time t+2 if they are able. The loan is “callable”, in that the bank can demand its money back after one period; if all banks call in the loans of a firm, they receive at most the liquidation value of the firm. A deposit made at time t can be redeemed at t+1 with a gross yield R if the bank is not in financial difficulties; if a bank cannot honor all claims, its creditors divide the available resources in proportion to their claims.

All transactions in the goods market are conducted in cash. The consumption good has a price p and the investment good costs q per unit. In each period the goods and financial markets operate according to the following pattern: banks can lend what cash they initially have on hand to firms, which are then able to buy the endowment from the young for investment; the young may deposit their income with the banks, which are then able to meet withdrawals of deposit plus interest by the old; the old and the government buy the output of firms (and any of the consumption good directly provided by the young), so firms receive the cash with which to repay loans to the banks. All going well, banks will have cash on hand at the start of the next period. The pattern of transactions in the economy is depicted in Figure 1.

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Flow of funds

Citation: IMF Working Papers 1992, 009; 10.5089/9781451927146.001.A001

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2. Two Equilibria

b. The “bad” equilibrium:

Another Nash equilibrium exists, characterized by autarky and the absence of intermediation and therefore of investment. Each period the young all convert their endowment into the consumption good, which is bought by the older cohort using their cash holdings. The available supply of the consumption good each period is KE_t, of which the government consumes γKE_t. Since the old spend their entire wealth on the consumption good, their budget constraint implies that

${\mathrm{P}}_{\mathrm{t}}=\frac{{\mathrm{M}}_{\mathrm{t}}}{\left(1-\gamma \right){\mathrm{KE}}_{\mathrm{t}}}\mathrm{.}$

None of the endowment is left over for investment. The young use only cash as a store of value and there is no intermediation.

For this to be a Nash equilibrium, it must be that no individual wishes to deviate from it, given the behavior of others. Suppose that an individual decides at time t to deposit his earnings with a bank, which then would be able to lend to firms to purchase some of the investment good. If everyone else holds cash and at t+1 the endowment will again be converted into the consumption good, and taking the price level as given, the individual who places his money on deposit will receive a gross return of at most p_t+1^s next period because, to honor his claim, the bank will have had to call in its loans early and real investments will have to be liquidated prematurely. But using the banks will be dominated by holding cash when p_t^K > p_t+1^s. If inflation is not too high, no individual will be motivated to break the autarkic equilibrium and banks never have any liquidity to lend to firms; the “bad” outcome is a Nash equilibrium. Because investments are long-term, confidence in banks depends on the soundness of their portfolio of existing loans and assets, not on the long-term potential profitability of new investments.

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The “good” equilibrium

Citation: IMF Working Papers 1992, 009; 10.5089/9781451927146.001.A001

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Notice that, as long as (1-γ)S > Ka², direct conversion of the investment good into the consumption good is sufficiently inferior to its conversion through the technology in the firms, and therefore just two possible Nash equilibria in pure strategies are possible: the intermediated economy and the autarkic economy. Suppose that there were a third equilibrium that stands between the other two. Every period the young hold back a fraction Φ, 0 < Φ < 1, of their endowment to convert directly into the consumption good and to sell to the old generation. Output from mature investments is (1-Φ)SE_t-2 and the young provide a further ΦKE_t of the investment good. Setting expenditure by the old cohort divided by the quantity they consume equal to price yields

${\mathrm{P}}_{\mathrm{t}}=\frac{{\mathrm{M}}_{\mathrm{t}}}{\left(1-\gamma \right)\left[\left(1-\mathrm{\Phi }\right){\mathrm{SE}}_{\mathrm{t}-2}+{\mathrm{\Phi KE}}_{\mathrm{t}}\right]}\mathrm{.}$

Firms, having borrowed M_t, buy up the residual supply of the investment good, implying a unit price of q_t = M_t/[(1-Φ)E_t].

An individual young person must have no incentive to change his behavior, taking prices and the behavior of others as given, for this to be an equilibrium. He chooses the share (1-ϕ) of his endowment to sell to firms and the share ϕ to convert directly into the consumption good so as to maximize his income (1-ϕ)q_t + ϕKp_t. If an equilibrium obtains, ϕ = Φ. As the problem is linear, an interior solution with 0 < ϕ < 1 requires q_t = Kp_t. ^31/ Substituting the expressions for q and p and rearranging, we obtain

$\varphi =\frac{\left(1-\gamma \right)\mathrm{S}-{\mathrm{Ka}}^2}{\left(1-\gamma \right)\mathrm{S}-{\mathrm{Ka}}^2-\left(1-\gamma \right){\mathrm{Ka}}^2}\mathrm{.}$

But by assumption (1-γ)S>Ka², so ϕ > 1, which is impossible. Hence there is no third equilibrium. With the available technology favoring long-term investment, the young have an incentive to supply as much of the investment good as possible if the banking system is operational.

3. Subsidies, Monetary Overhang, and Suppressed Inflation

It is widely accepted that the socialist economy of Eastern Europe had evolved into a system of rationing, controlled prices and subsidization through the financial system. In this subsection a representation of such a system, which is fully intermediated by a banking sector, will be developed.

The traditional socialist financial system was, as it were, locally stable, in that government manipulation of administered prices, fixed interest rates, and the provision of subsidies ensured the continued liquidity of all institutions. The sustainability of the system, however, was undermined by the growing discrepancy between the stocks of banks’ assets and liabilities, and by the widening gap between administered and world market prices.

Banks start some period t with M_t, which they lend to firms at a two period rate of interest L. Firms receive in addition a “quasi-fiscal” subsidy π₁M_t from the monetary authority, and use their combined liquidity to bid for the investment good, the price of which is flexible; in equilibrium price equals expenditure divided by quantity, so q_t = M_t(1+π₁)/E_t. ^{32/ 33/} The firms end every period with zero net worth and the subsidy π₁M_t measures the losses incurred in their operations measured at the prevailing prices.

With a positive interest rate on deposits (R>1), the young prefer to place their cash income with the banks, which are therefore able to meet withdrawals by the older generation. To determine the rate of interest on deposits it is assumed that the banks must have just enough cash on hand to meet all potential withdrawals: the current old generation deposited M_t-1(1+π₁) in period t-1, which has since grown by a factor R; the bank now holds M_t(1+π₁) in liquid form; hence with a constant rate of subsidization the interest rate just equals the rate of growth of money supply from period to period (R = M_t(1+π₁)/M_t-1(1+π₁) = M_t/M_t-1).

The price of the consumption good is fixed artificially low at ${\hat{\mathrm{p}}}_{\mathrm{t}}$, which is always below the market-clearing price. The government still buys a fraction γ of the available supply (SE_t-2) of consumer goods at the low price. Hence the money supply must be increased by an additional amount

to finance public consumption. The old are rationed in the market for the consumption good and therefore cannot spend all their wealth; they need actually withdraw only ${\hat{\mathrm{p}}}_{\mathrm{t}}\left(1-\gamma \right){\mathrm{SE}}_{\mathrm{t}-2}$ from the banks to make what purchases they can. Their remaining deposits are bequeathed to the young of period t. Firms earn ${\hat{\mathrm{P}}}_{\mathrm{t}}{\mathrm{SE}}_{\mathrm{t}-2}$ in revenues with which to repay banks their debt service obligations LM_t-2. The banks end the period with cash holdings of M_t(1+π_0t+π₁) = M_t+1. ^34/

A few features of this economy with subsidies to firms and suppressed inflation are noteworthy. First, the input market is not rationed and q_t/q_t-1 = (1+π_0t-1+π₁)/a, so the price of the investment good inflates as long as the money supply grows faster than the endowment.

Second, were there no rationing in the goods market, the market clearing price would be given by

Thus, the market clearing price also grows at the same rate as the input price. A natural definition of suppressed inflation is

Thus if ${\hat{\mathrm{p}}}_{\mathrm{t}}$ is not adjusted by an average factor of [1+π_0t-1+π₁]/a per period, seigniorage as a share of the outstanding money stock approaches zero and the degree of suppressed inflation becomes infinitely large. A very large degree of suppressed inflation encourages black-markets and threatens a sudden collapse into the autarkic mode with endowments directly converted into the consumption good by the inefficient kitchen-garden technology. If the system is to survive, controlled prices must be inflated. Henceforth it will be assumed that ${\hat{\mathrm{p}}}_{\mathrm{t}}$ is indeed suitably adjusted and that π_0t is constant.

Third, the “forced” bequests by the older generation, which equal the excess of savings over expenditure

is a measure of the “monetary overhang”, the relative amount of excess liquidity which will put pressure on the goods market if prices are liberalized.

1. Withdrawal of Price Control and Subsidies

a. The limitation of subsidies to enterprises and the liberalization of prices can be considered in the first instance a distributional disturbance; profitable sectors that were heavily burdened before and those who lost through the inflation tax are to gain at the expense of those sectors that were used to receiving budgetary or quasi-fiscal transfers and benefiting from other privileges. Despite freed prices, the latter may become illiquid or even insolvent. Their bankers in turn may be forced to demand the liquidation of their assets, but even so banks may face their own liquidity crisis. Existing capital may be destroyed and new investment may go unfinanced as each individual, bank and enterprise strives to maintain its own position. The spread between lending and deposit rates increases, if financing is available at all. While negative net investment may sustain consumption for a time, the multiplier effect of the banking crisis and its long-term effect on the capital stock can be severe. Recovery may be slow and halting, and relative prices may remain far from their long-run equilibrium as demand for inputs remains low.

b. Suppose that at the start of some period t the government decides to stop all subsidies and to liberalize prices. Then, as will be shown, a Nash equilibrium outcome is for the banks not to lend for new investments, the young to convert their endowment into the consumption good, all loans to be called in during period t, and for output to fall drastically and recover slowly. ^36/

Start with the old in period t. In an effort to purchase as much as possible of the consumption good they will wish to withdraw the whole of their deposits, which amount to a claim of M_t(1+π₁) on the banks. ^37/ But the banks certainly cannot have enough cash on hand, because the government has stopped the subsidy to firms and the entire supply of “outside” money is fixed at only M_t. In this sense there is a rational bank “run”. Each individual bank will try to generate liquidity to honor its obligations, first by eliminating lending at the start of the period to preserve its initial cash holdings, and then by calling in loans made in period t-1. ^38/ The investments liquidated after one period yield an output of sE_t-1.

For every bank acting alone, restricting lending and calling in loans is wise, but for the system as a whole the price level falls as the supply of the consumption good increases, so banks can never acquire enough liquidity. Indeed, from a global point of view the banks could lend to the firms at the start of the period and get back liquidity in the form of deposits from the younger generation, but each single bank is afraid that what it lends will end up as deposits with other banks. ^39/ Investment financing is unavailable at any price.

With no lending for investment, the young of period t see no demand for their endowment unless they convert it into the consumption good. Total supply of the consumption good in period t is

C_t = [SE_t-2 + sE_t-1 + KE_t],

made up of the output of mature investments, liquidated early investments, and the transformed endowment. The old have benefitted from the transformation of capital into consumables, but there is no capital left to produce the consumption good in periods t+1 and t+2. ^40/ The budget constraint of the old determine the price of the consumption good as

Note that the consumption good is certainly priced below what it would be, given the money supply, in the baseline equilibrium with successful intermediation, because its supply has temporarily increased. It is quite possible, however, for p_t to be substantially above ${\hat{\mathrm{P}}}_{\mathrm{t}-1}$, the previous administered price.

Income from the sale of the consumption good is split between the young generation and the firms, who use their share to repay banks as much as they are able. Due to government consumption of γC_t, continued seigniorage raises the money stock to M_t+1 = M_t/(1-γ). The young of period t deposit their cash income

with the banks at the end of period t in exchange for a promise of M_t+1 next period; the offer of a positive nominal return (R_t = C_t/KE_t) makes depositing with the banks superior to storing wealth as cash.

c. The banks start period t+1 with a total of M_t+1 in cash, no loans outstanding and liabilities to the period t cohort. A Nash equilibrium is for the banks to lend their cash to new firms, which purchase part of the t+1 cohort’s endowment. The young redeposit this cash with the banks, allowing withdrawals to be met in full.

Equilibrium in the goods markets is achieved at an interior solution; the young are indifferent between selling their endowment to firms and converting it into the consumption good and selling it to the old. If, say, q_t+1 > p_t+1^K, the young would wish to sell all their endowment to the firms, but then the old would bid up the price of the consumption good, for otherwise they would obtain nothing; if q_t+1 < p_t+1^K, the young would convert all their endowment into the consumption good, but then firms would bid for them not to do so. Hence the condition for equilibrium is the interior solution q_t+1 = p_t+1^K. The new price of the input relative to the output price is lower than at market clearing levels in the socialist economy or in the successfully intermediated economy, and even lower than the input price relative to the old administered output price.

Consider first the behavior of households. Let the t+1 cohort reserve a proportion Φ_t+1 of their endowment to convert into the consumption good and sell to the old cohort and government. There is no capital stock inherited from previous periods, so the supply of the consumption good is just C_t+1 = Φ_t+1KE_t+1. With the government purchasing a fraction γ of the supply of the consumption good, equilibrium prices are

and

Using the condition for an interior solution yields Φ_t+1 = 1/(2-γ). Note that p_t+1 > p_t because the supply of consumption goods has shrunk due to the lack of productive investment and the conversion of only some of the endowment into the consumption good. Period t+2 is similar because as yet there is no mature investment and the banks have no incentive to call in loans made at t+1.

The young of period t+1 receive the full money stock (M_t+1 + ΔM_t+1 = M_t+2). Banks will not be able to offer a positive nominal rate of interest because withdrawals during t+2 will be made before the government injects new money; at best the young obtain a real return on their wealth of (1-γ)a, which could well be negative. If the young hold their wealth as cash the economy will fall into the “bad” equilibrium without intermediation. Here it will be assumed that bank deposits offer some small nonmonetary advantage over holding cash.

In contrast, firms borrow M_t+1 at the start of period t+1, which they repay with their earnings p_t+3SΦ_t+1E_t+1 two periods later. Inverting the expression for p_t+1 to solve for M_t+1, and using the expression for Φ_t+1 given above allows one to show that the real return on the investment is S/K, where the consumption good is the numeraire. Hence by the zero profit condition firms face a positive real borrowing rate and, in normal circumstances, positive nominal rates. The term structure steepens and lending and deposit rates diverge, which are phenomena observed in the countries of Eastern Europe.

In subsequent periods t+2+i (i = 1,2,…) there is some production (1-Φ_t+i)SE_t+i from investment in period t+i. The t+2+i cohort reserves a fraction

of its endowment to be converted into the consumption good. Slowly output and investment recover as the successful, intermediated equilibrium is approached. Recovery may be protracted and for certain parameter values oscillations may be induced. The relative price of the input remains at q/p = K, below its long-run equilibrium level, so long as Φ_t+2+i remains greater than zero.

An example of the behavior of the economy after the withdrawal of price controls and subsidies is shown in Figures 3(a) and 3(b). ^41/ Investment collapses and recovers only slowly and with fluctuations following the removal of controls at t = 0. After an initial surge, consumption is restricted by the limited supply, which in turn induces the young of each period to convert part of their endowment into the consumption good. Inflation is sharp but variable as the new long run equilibrium is slowly approached.

d. Note that it is the combination of liberalizing prices and stopping subsidies after a history of repressed inflation that generates these fluctuations in output and prices. Suppose that the government continued to dictate ${\hat{\mathrm{P}}}_{\mathrm{t}}<{{\mathrm{P}}^{*}}_{\mathrm{t}}$ and ration the consumption good, but firms lose their subsidies. Then firms could only pay a total of M_t for inputs and the banks would have less cash than anticipated in the middle of the period. Firms would not be able to service all their debts, but a banking collapse need not be triggered by this one-off capital loss because the old have no incentive to withdraw more than what they can spend, namely, an amount $\left(1-\gamma \right){\hat{\mathrm{P}}}_{\mathrm{t}}{\mathrm{SE}}_{\mathrm{t}-2}$. Alternately, if subsidies had continued but the price of the consumption good was freed to equilibrate that market, firms would still start the period by buying the endowment for M_t(1+π₁), which the young would deposit with the banks; the banks would then have enough cash in hand to meet the demand for withdrawals, and firms would earn enough that they can service their debts. An investment collapse can be avoided at the expense of higher inflation, which has no real costs in this model.

However, even if subsidies had been absent, price liberalization leads to a banking collapse when there are index-linked returns on deposits. Deposits denominated in foreign currencies, which were common in many countries of Eastern Europe, become index-linked deposits with the pursuit of devaluation in line with inflation. Let the one-period gross nominal return on deposits be set at R_t = rp_t-/p_t-1, r>1. If prices are liberalized at t, the price level moves up from ${\hat{\mathrm{p}}}_{\mathrm{t}}$, and the nominal claims on banks increase equi-proportionately, but the available liquidity is fixed at M_t. Banks’ efforts to meet demand for withdrawals will again lead to a collapse of investment and the calling-in of existing loans.

e. If there are strong microeconomic and political grounds for the speedy removal of price controls and subsidies, financial policies may be devised that in effect slow the impact of the transition on the financial sector.

At first glance it may seem that the wholesale writing-off of preexisting liabilities would eliminate many of the transition costs, because enterprises and banks would be freed of obligations that they cannot meet. However, such a dramatic move would be distributionally unacceptable, because the old cohort would be left with nothing, and it would leave the economy at the “bad” equilibrium without intermediation. Within the confines of the model presented here, a more promising solution would involve the expropriation of part of the deposits of the old by a partial suspension of convertibility. If the deposit claims of the old cohort in period t could be reduced from (1+π₁)M_t to M_t by fiat, banks would be able to acquire enough liquidity from new deposits by the young to meet their obligations, and so they would not have to restrict lending or call in loans. Banks would still suffer a capital loss on outstanding loans. However, in a more elaborate model such a betrayal of people’s confidence in the banking system may have long lasting effects on the reputation of financial institutions and the government.

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Effects of removing price controls and subsidies

Citation: IMF Working Papers 1992, 009; 10.5089/9781451927146.001.A001

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A nearly equivalent but more subtle policy would provide a transfer of π₁M_t to the banks so that they can meet their short term obligations. Inflationary pressure would be accommodated, causing p_t to rise. A danger here is that, if an attempt is made to make the increase in the money supply transitory by removing π₁M_t next period, banks may be unable to offer a positive nominal rate of interest; the young in period t will prefer to hold their wealth as cash and the economy will fall into the “bad” equilibrium without intermediation. Furthermore, if banks have index-linked liabilities, the increase in p_t will exacerbate the banks’ difficulties and the transfer to them will be insufficient to meet their liquidity needs.

Therefore a temporary tax on the consumption good may be a useful adjunct to direct intervention in the financial system. Besides discouraging the direct conversion of the endowment into the consumption good, such a tax would reduce nominal demand and slow inflation, thus limiting banks’ index-linked liabilities and generating revenue for government, which would not have to rely so much on seigniorage. However, enterprises would then not receive sufficient revenue to make all loan repayments due in periods t and t+1. Further subsidies, to service their debts rather than to purchase inputs, would be necessary to keep the system operating; these subsidies need not be channeled through firms but could be given directly to banks. ^42/ The model presented here suggests, then, that a practical way to ease the transition from a repressed, administered economy to one with flexible prices and a “hard” budget constraint is to reassign funds that had been used to subsidize enterprises and support government consumption to the servicing of financial obligations, to accept some inflation during the transition, and to concentrate taxes on the consumption good.

2. Divergent Movements in Returns on Existing and New Capital

a. The imposition of financial discipline ought itself to have a real effect as enterprises adjust production levels, management and work procedures to improve profitability. Eastern European industry also faces radical changes in the competitive structure of domestic and foreign markets for both inputs and outputs, for example because of the disbanding of the CMEA, while novel Western technology and techniques are introduced and the regulatory and macroeconomic environments are transformed. Existing capital has been depreciated yet new investment opportunities that have the potential for high productivity and profitability have been created. The danger is that, if the “real” shock is large, the insolvency of enterprises will lead to their immediate and wholesale liquidation. While consumption may initially be cushioned, investment and the demand for inputs will slump. The old, relatively unproductive capital will be scrapped before new investments mature, and so the effects of the shock will be magnified in later periods. A temporary disturbance may be transmitted through the banking system and result in persistent volatility in output and relative prices.

Following the lead of Bernanke (1983), in this section it is shown that these shocks can be perpetuated and magnified by financial linkages between investments and across time. In particular it will be assumed that firms are long lived, and that, in any period, a firm is engaged in new investment, the development of investments made one period ago, and the exploitation of mature investments. If a firm is unable to meet its debt servicing obligations, its bankers are allowed to seize and liquidate its assets. New investments have no immediate liquidation value.

b. In order to concentrate on real rather than monetary phenomena, here the peculiar features of socialist economies such as fixed prices and permanent subsidies will be ignored. Consider the “flexprice” economy where intermediation is successful and sustained, with a “good” equilibrium as described in section III.2. At the end of period t the firms are due to repay M_t+1 = p_tSE_t-2 to the banks, having borrowed M_t-2 in period t-2 to finance the now mature investments.

Suppose now that the economy suffers a temporary negative real shock at t that reduces the productivity of existing capital (i.e. that maturing in periods t and t+1) from S to S’; the productivity of new investment rises permanently to S″, S″> S. ^43/ If no capital is liquidated and the entire endowment continues to be invested each period, the price level at t and t+1 would rise to offset the fall in S and firms would have enough revenue to meet their (nominally defined) liabilities; the price level will fall relative to that after period t+1; the ex post real interest rate will fall and then briefly rise; the entire adjustment effort is borne by current generations.

However, if S’ is sufficiently low, the rise in the price of the consumption good may alter the behavior of the young of periods t and t+1. Once the young start converting some of their endowment into the consumption good, there will be less of the investment good available to take advantage of the improved productivity of new capital. Furthermore, firms will not receive enough revenue to meet their obligations, and so banks will call in some loans prematurely. While consumption immediately increases, the capital stock is eroded and consumption is reduced for several periods into the future. The source of these large and persistent effects is the presence of long-term contracts between banks and firms and the durability of capital.

Specifically, assume that the government continues to purchase a fraction 7 of the output of the consumption good. In period t the young reserve a proportion Φ_t, 0 ≤ Φ_t ≤ 1 of their endowment to convert into the consumption good at rate K. Only (1- Φ_t)E_t of the endowment is invested. As will become apparent, firms cannot generate enough revenue to repay all debts even when all investments made in period t-1 are liquidated. Then banks, acting individually, will demand the maximum repayment, even if they have to close down firms. Since firms invested E_t-1 in period t, the liquidation of these immature investments yields sE_t-1. By assumption the investment of (1-Φ_t)E_t made at the start of the period has no resale value or is not undertaken by new firms. Hence the total supply of the consumption good is C_t = Φ_t-KE_t + S’E_t-2 + sE_t-1. Deposits by the young allow banks to meet their obligations M_t to the old cohort. Prices are determined by equating financing to nominal expenditure:

and

In order for an equilibrium to obtain at an interior solution, the young must be just indifferent between selling their endowment of the investment good and converting it into the consumption good, which occurs when q_t = Kp_t. Again the relative price of the investment good falls. Using the expressions for p_t and q_t and the fact that E_t = aE_t-1 = a²E_t-2, it can be shown that

if an interior equilibrium exists. Certainly Φ_t < 1, and Φ_t > 0 if

Ka² > (1-γ)(S′ + sa).

If this last inequality is not met, the “kitchen garden” technology is so inefficient that the young do not have an incentive to convert any part of their endowment; p_t rises enough that firms obtain enough cash to repay their debts without liquidating any immature investments; the transition through the periods of low productivity and on to the periods of higher productivity is quick.

If, however, the real shock is large, its effects will be long lasting and complex. When Φ > 0, by substitution it can be shown that production of the consumption good in period t will be

and correspondingly only (1-Φ_t)E_t of the endowment is invested in the new technology despite its superior productivity. Since enterprises earn

but have obligations of M_t+1, they are insolvent even after the liquidation of all their investments if Φ_t > 0. ^44/

c. In period t+1 no mature capital is left to produce the consumption good, so its entire supply is generated by converting the endowment; it can be shown that in equilibrium Φ_t+1 = 1/(2+γ). ^45/ Output increases somewhat in period t+2 because limited investment occurred in period t and because productivity has increased to S″, but it is possible that some of the endowment will still be used for consumption. Subsequently the economy can take many periods to return to maximum investment and consumption despite the improvement in technology. Because investments are long-term while the shock results in the liquidation of capital of all vintages, recovery need not be monotonic; rates of investment, output and relative prices may fluctuate as they converge towards their new equilibrium paths. The real interest rate charged to borrowers jumps at period t, but the rate to depositors falls; convergence occurs as long-term equilibrium is reestablished.

The equilibrium reaction of the economy to a large real shock is illustrated in Figures 4(a) and 4(b). ^46/ The decline in the return on existing capital occurs at t=0. Rather than accepting a brief reduction in consumption and maintaining investment, the impact of the shock on consumption is delayed but magnified and perpetuated by the uncoordinated actions of banks, firms and the sequence of consumers. Disturbances to relative prices induce some of the endowment to be used for immediate consumption, and investment is correspondingly lower.

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Effects of a large real shock

Citation: IMF Working Papers 1992, 009; 10.5089/9781451927146.001.A001

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d. A transitory real disturbance with persistent effects presents in some ways a more complex policy problem than the removal of subsidies and price controls. Policy needs to be directed both towards the rapid attainment of a “good” long run equilibrium, and to ensuring the optimal degree of consumption smoothing. An unavoidable real cost has to be borne, and the intergenerational distribution of this cost is an essentially political issue.

Suppose, first, that the aim is to keep investment equal to the endowment each period and to prevent the premature liquidation of capital; those who consume in periods t and t+1 make the maximum effort on behalf of future generations. To remove the incentive for the young cohort to convert their endowment directly into the consumption good, policy must ensure that q_t > Kp_t, and to prevent firms becoming insolvent they must have at least M_t+1 in hand towards the end of period t when loan repayments fall due.

One method to achieve these intermediate targets would begin by subsidizing firms’ purchases of the investment good, financed by money creation. ^47/ It is always possible to subsidize the purchase of the input enough that none is converted into the consumption good. The old may then withdraw the full amount M_t from their bank deposits, which they spend on their share (1-γ)S’E_t-2 of the supply of the consumption good. Including revenue from sales to government, firms earn enough to repay their loans from the banks due to the large rise in the price of the consumption good; no revenue is earned by the young by selling the consumption good. Hence the banks do not call in any loans, the pre-existing capital stock is preserved for the next period, and the whole endowment is invested. The outside money created to finance the subsidy can be eliminated through taxation and reduced government consumption in subsequent periods. ^48/ Only temporary inflation in input prices is accepted.

A smoother path of consumption can be achieved if some of the endowment is not invested. Such behavior can be induced by setting q_t = Kp_t after net taxes, and ensuring that firms have the revenue to service their debts. ^49/ A subsidy on the investment good, say at a rate σ, can be chosen to determine the desired proportion of the endowment converted. Since

C_t = ΦKE_t + S’E_t-2,

p_t = M_t/[(1-γ)C_t],

and

in equilibrium

Note that Φ is strictly decreasing in σ, so the desired level of Φ can always be achieved. ^50/ The old withdraw M_t from banks and spend it on consumption goods produced by both the young cohort and enterprises, so the latter will not receive enough revenue from sales alone to meet all their obligations to the banks. Hence additional subsidies will be needed to prevent foreclosures. A similar pattern of subsidies on investment goods and to enterprises will be needed in period t+1 when old, inefficient capital installed in t-1 matures.

The model has only one final good and one input, and the scope for improving allocation is restricted to the choice of only a few technologies. Nor does the model take into account the possibility of intertemporal substitution of consumption by an economic agent. It also abstracts from the issue of allocation of inputs to the production of alternative consumer goods as well as the distinction between efficient and inefficient state firms. But the paper does predict the complications that bank insolvency may generate during the process of reform. We conjecture that the broad thrust of the results will survive even if greater substitution possibilities, across both time and goods, and heterogenous firms are introduced into the model.